Largest Widening CDS Spreads: Guess Who?

OK, Rabobank is in first place and Safeway (UK) is in second and Sweden is in third. However, if you guessed Italy, then you still get a gold star. That’s what has my attention. The 5-Year credit default swap spread for Italy is now at 181 basis point and moving higher as contagion starts to infect other countries in the euro zone.

Here our thoughts regarding the rumored downgrade of Italy. While we remain negative on the ratings for peripheral euro zone, we don’t think a downgrade of Italy is a sure thing. Its numbers have always been bad, and have in fact stayed remarkably stable during this crisis even as the rest of the periphery blew up. With rating agencies on the warpath, we can’t rule out a downgrade, but the case for a downgrade of Italy isn’t as glaringly obvious as the others in the periphery.

Our sovereign ratings model currently has Italy at A+/A1/A+ vs. actual ratings of A+/Aa2/AA-. Moody’s is most out of line (by two notches) but S&P is on target and Fitch is off by one notch. As a point of reference, the implied ratings for Italy, Ireland, Portugal, and Greece all started out at A+/A1/A+ when we began the model in June 2009. But since then, Italy’s implied rating has remained at A+/A1/A+ even as those for Portugal, Ireland, and Greece have sunk to A-/A3/A-, BBB/Baa2/BBB, and BB/Ba2/BB, respectively.

The downgrade to credit watch negative came this past week, when S&P downgraded Italy to credit watch negative. But since the ratings agencies have been very aggressive in downgrading (to make up for past sins during the housing bubble), we should expect action from Fitch and Moody’s here as well. When the pejorative acronym PIGS was first created, it was supposed to be a moniker for the southern European states (Portugal, Italy, Greece and Spain). However, Italy has done much better than housing-crisis stricken Ireland and so Ireland is now in the periphery instead of Italy. What we need to watch out for is contagion. Italy is the most vulnerable. But Belgium and France are two other weak euro zone credits, which both could face some mild downgrade pressures due to contagion.

Win Thin frames it this way:

With regards to Belgium, we suspect that if there is still no government in Belgium by mid-June, it will likely be downgraded by S&P, which it threatened to do near the start of this year. In other words, it is possible that the next country that gets their rating cut could very well be a core and not a peripheral country. That would certainly get the market’s attention.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.

I would be curious what you think about this idea: The great EU debt write off Me thinks it is a very cool idea. Won’t solve the problem of Greece. But will clear things so we can focus on the real problems.

Anonymous says 8 years ago

Mostly the government bond holders are not other governments, but institutions like banks that operate in given country. While one bank holds bonds over third party it may owe to another bank simultaneously. The idea of carry trading, i.e. banks get infinite liquidity from ECB from bonds, regardless of their rate, will flourish there.

In theory I have supported same ideology, because as Ireland and many other European countries have nationalised their banks in trouble the picture could be simplified even more.

The real option, which I think we are going to see is that ECB plays Pokemon (Gotta catch ’em all) with government bonds, then prints equivalent amount of euros and case is settled. Mr. Trichet (or Mr. Draghi, depending on starting date of the operation) can always ask professional guidance from Mr. Bernanke.

So, you’re right, principle reduction is key. The problem with the cancelling swaps in the piece you linked to is that each debt contract is between two parties and their claims don’t net. These claims might net at the aggregate country level but real people who have their own narrow firm-specific interests are behind those contracts. And those people have no interest in the greater issues, just in getting their money back.

DavidLazarusUK says 8 years ago

While it would clear up the problems the real issue is that the banks would have to take losses. Why would they accept such a deal when they currently have the governments to bail them out without loss. Even then they would refuse such deals if they throught that they would not come out ahead. It does nicely illustrate the benefits of capital controls on the banks. If banks could only lend abroad if they had central bank permission or accept deposits with permissions it could stop the situation like in the perphery where incoming money inflated a market well past its normal burst point.

DavidLazarusUK says 8 years ago

While it would clear up the problems the real issue is that the banks would have to take losses. Why would they accept such a deal when they currently have the governments to bail them out without loss. Even then they would refuse such deals if they throught that they would not come out ahead. It does nicely illustrate the benefits of capital controls on the banks. If banks could only lend abroad if they had central bank permission or accept deposits with permissions it could stop the situation like in the perphery where incoming money inflated a market well past its normal burst point.

I would be curious what you think about this idea: The great EU debt write off Me thinks it is a very cool idea. Won’t solve the problem of Greece. But will clear things so we can focus on the real problems.

Anonymous says 8 years ago

Mostly the government bond holders are not other governments, but institutions like banks that operate in given country. While one bank holds bonds over third party it may owe to another bank simultaneously. The idea of carry trading, i.e. banks get infinite liquidity from ECB from bonds, regardless of their rate, will flourish there.

In theory I have supported same ideology, because as Ireland and many other European countries have nationalised their banks in trouble the picture could be simplified even more.

The real option, which I think we are going to see is that ECB plays Pokemon (Gotta catch ’em all) with government bonds, then prints equivalent amount of euros and case is settled. Mr. Trichet (or Mr. Draghi, depending on starting date of the operation) can always ask professional guidance from Mr. Bernanke.

So, you’re right, principle reduction is key. The problem with the cancelling swaps in the piece you linked to is that each debt contract is between two parties and their claims don’t net. These claims might net at the aggregate country level but real people who have their own narrow firm-specific interests are behind those contracts. And those people have no interest in the greater issues, just in getting their money back.

Anonymous says 8 years ago

While it would clear up the problems the real issue is that the banks would have to take losses. Why would they accept such a deal when they currently have the governments to bail them out without loss. Even then they would refuse such deals if they throught that they would not come out ahead. It does nicely illustrate the benefits of capital controls on the banks. If banks could only lend abroad if they had central bank permission or accept deposits with permissions it could stop the situation like in the perphery where incoming money inflated a market well past its normal burst point.

Contagion is relevant as systemic risk is the main problem and not some correlation of idiosyncratic risk of diverse Eurozone member economies! The rat is in the structure and not in diversification and/or hierarchy of the member economies of the common currency area!

@yahoo-R4CD7YTHFYQEUF5KOFPNE4UJMQ:disqus Even when an entity has been bought out, it often still exists as a legal entity afterward. Meaning it can take on debt. Safeway continues to operate as a separate legal entity. Last month Moody’s had affirmed it’s rating at A3, outlook stable.

@yahoo-R4CD7YTHFYQEUF5KOFPNE4UJMQ:disqus Even when an entity has been bought out, it often still exists as a legal entity afterward. Meaning it can take on debt. Safeway continues to operate as a separate legal entity. Last month Moody’s had affirmed it’s rating at A3, outlook stable.

Anonymous says 8 years ago

EDIT: Oops, this was supposed to be a reply to David Lazarus UK. I fumbled with my mouse and backwarded the page, then returned and wrote it finish. Then to the reply:

If we needed to locate the hooved, red-skinned and horned figure, I’d first point to ECB. It basically declared that lending euro-nations is free of risks and even encouraged to do so. Ok, we had several nations past the EU agreement of 60% debt-to-GDP ratio before the Lehman’s. Out from the blue Greece says its book keeping does not match. Then Irelands’ banks were gasping for life. Portugal, then again is the shadowy assassin, took steps in silent towards indebtness. It also accepted the companies that agreed to improve infrastructure.But the time Greece and Ireland were put into troubled stagelights there wasn’t anything to do anymore.

The banks, on the other hand, didn’t much care to make any surveys after ECB’s encouragement. I admit I had not much to expect when I saw olympic opening ceremonies in Athens 2004. It was a year or two after I got deeply interested in European debt, as well as in subrime lendind in the US. But now, after years of surveying all the possible sources I can imagine I am confident to say that if we needed to pinpoint down the culprit (of European debt crisis), we should start from ECB.

About Italy. I personally thought Italy would have been the next on line after Greece. Of course, the Irish methodology surprised me, hands down. I think Spain remains “a serious threat”, because of asset value declinings in properties. It’s still silent. Everyone knows that if Portugal does not get its fix the Spain is screwed. But Italy has been sailing there with capital-torn sails high on open seas of debt. It has been explained that because Italy has lots of industry and capability there the debt-to-GDP is not much of a concern.

Until now?

Anonymous says 8 years ago

EDIT: Oops, this was supposed to be a reply to David Lazarus UK. I fumbled with my mouse and backwarded the page, then returned and wrote it finish. Then to the reply:

If we needed to locate the hooved, red-skinned and horned figure, I’d first point to ECB. It basically declared that lending euro-nations is free of risks and even encouraged to do so. Ok, we had several nations past the EU agreement of 60% debt-to-GDP ratio before the Lehman’s. Out from the blue Greece says its book keeping does not match. Then Irelands’ banks were gasping for life. Portugal, then again is the shadowy assassin, took steps in silent towards indebtness. It also accepted the companies that agreed to improve infrastructure.But the time Greece and Ireland were put into troubled stagelights there wasn’t anything to do anymore.

The banks, on the other hand, didn’t much care to make any surveys after ECB’s encouragement. I admit I had not much to expect when I saw olympic opening ceremonies in Athens 2004. It was a year or two after I got deeply interested in European debt, as well as in subrime lendind in the US. But now, after years of surveying all the possible sources I can imagine I am confident to say that if we needed to pinpoint down the culprit (of European debt crisis), we should start from ECB.

About Italy. I personally thought Italy would have been the next on line after Greece. Of course, the Irish methodology surprised me, hands down. I think Spain remains “a serious threat”, because of asset value declinings in properties. It’s still silent. Everyone knows that if Portugal does not get its fix the Spain is screwed. But Italy has been sailing there with capital-torn sails high on open seas of debt. It has been explained that because Italy has lots of industry and capability there the debt-to-GDP is not much of a concern.